Brexit…Pursued by a Bear?

By: Erik Knutzen | 04 Jul 2016

When the UK voted to leave the European Union, I happened to be in the thick of it, on a business visit to London. When I turned in on the night of 23 June, the opinion polls showed the race to be neck-and-neck, but financial markets were increasingly confident that a “Remain” vote would be returned. The comment we published the next morning was not the one we’d anticipated.

You had to be there to get a good sense of the shock the “Leave” vote caused. It has set off the UK’s biggest political and constitutional upheaval in 70 years. But what do markets make of it all?

Large-cap equities erase losses

Our initial response was to convey our view that fears of a “Lehman moment” were overblown. The vote hadn’t changed the fact that we are in a slow-growth, low-inflation, low-interest rate environment. Sure enough, the FTSE 100 Index powered back through its pre-Brexit level at the end of last week. The S&P 500 Index has also been reversing its losses. Global risk assets were recovering even before Bank of England governor Mark Carney boosted them by hinting at “some monetary policy easing” over the summer. It looks like our first instinct was a good one.

We have now experienced a handful of these V-shaped moves in markets over the past two years, over which time both the price and the earnings of the S&P 500 have remained virtually unchanged. Indeed, it’s the “slow, low, low” background that is both stagnating earnings and allowing specific or localized shocks to cause outsized short-term volatility; it makes the margin of error for investors so thin.

And there is no shortage of additional potential shocks coming our way. The US still has to choose between two (at least publicly) anti-trade presidential candidates in November, and Spain’s latest general election kicked off an 18-month cycle that will include Germany, France, Italy and the Netherlands. But as long as the underlying fundamentals remain unchanged, volatility from these events can create opportunity, which is why we stress the importance of focusing on fundamentals rather than news headlines. Amid the noise of last week, for example, the Atlanta Fed raised its forecast for US Q2 real GDP growth to 2.7%, while the eurozone printed a positive headline inflation number and its lowest unemployment in five years.

The impact has been localised

This is not to say that the vote hasn’t inflicted damage. At the end of last week, the FTSE 250 Index, which better represents the UK economy than the global, often US dollar-earning companies of the FTSE 100, was still some 5% short of pre-Brexit levels. European stocks remained down by a similar amount. This is as challenging for the EU as for the UK itself: Standard & Poor’s downgraded both entities last week.

And then of course there is the pound sterling. Its 8% one-day drop against the US dollar on 24 June was the biggest since the end of Bretton Woods. A recovery last week was stopped in its tracks by those comments from Mark Carney.

So far, so rational. Global markets in general have recovered, with those most exposed to the longer-term implications of “Brexit” re-priced for weaker performance.

Still “slow, low, low”— but more so

Where the vote has had a broader impact, it’s “more of the same”. “Brexit” hasn’t changed the “slow, low, low” dynamic, but may have amplified it. Fed Funds futures now forecast that the US central bank will be on hold at least into next year. The prospect of monetary tightening disappearing over the horizon has driven bond yields lower. The two-year UK Gilt yield went negative for the first time last week, the entire Swiss curve is dipping in and out of negative territory and the German Bund yield has sunk to uncharted depths. And now the 10-year US Treasury yield is also flirting with historic lows.

This puts banking-sector profits under more pressure: at the end of last week European banks were still down 15%-20% since the vote, but US banks remained down 4%-5%, too. But does it forecast similar gloom for non-financial corporate earnings? We think bonds are being pushed by technical pressures rather than fear of an outright collapse in growth and earnings—and so far equity markets appear to agree.

Nonetheless, we believe this is a time for caution, not complacency. If the UK’s voters have articulated a cry of rage against trade and globalization that is heard and echoed further afield, we could see more than a localised effect on growth prospects. In Spain the electorate responded to “Brexit” by moving back towards the center, but there are still many more occasions for political risks to spill into global economic fundamentals—and for markets to hit bumps that are much harder to overcome.